Investment fundamentals
what you need to know
If you’re just starting out as an investor, there’s a lot of information to absorb. This fact
file defines and explores the pros and cons of each asset class, why certain asset
classes are more appropriate for different types of investors and why no asset class
consistently outperforms the others.
Shares
Snapshot
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Cash, fixed interest, property and shares are the
four main asset classes.
Defensive investments include cash and fixed
interest.
Growth investments include property, shares
and alternatives.
Generally the higher the return, the higher the risk.
Diversifying your portfolio and investing over the
long term can help reduce this risk.
A share represents part ownership of a company. Shares
are generally bought and sold on a stock exchange.
Returns usually include capital growth as well as income
from dividends. You can choose to invest in Australian
shares, global shares or a mix of both.
Time horizon: five to seven years (long term)
Defensive vs growth investments
The main asset classes can be separated into two broad
groups – defensive and growth investments.
Cash and fixed interest
Understanding asset classes
Most investments fit into one of four main categories or
asset classes:
Cash
Cash includes money in bank accounts, as well as
investments in bank bills and similar securities and some
short term (up to 12 months) term deposits. Cash
investments provide stable, low-risk income in the form of
regular interest payments.
Time horizon: short term
Fixed interest
Fixed interest investments include term deposits,
debentures, mortgages, and government and corporate
bonds. The income return is usually in the form of regular
interest payments for an agreed period of time. For fixed
interest investments that are tradable (eg bonds), there is
the potential for capital growth or decline depending on
interest rate movements.
Time horizon: one to three years
Property
You can invest in property directly (eg when you buy a
house or commercial premises such as a shop or office) or
indirectly (eg by purchasing units in a property trust that is
listed on a stock exchange). This asset class includes
residential, commercial, retail, hotel and industrial property.
Time horizon: three to five years (medium term)
Defensive investments, such as cash and fixed interest aim
to provide investors with regular income at relatively low
risk. They generally experience only slight fluctuations in
investment returns and values over short periods. The
downside of this security is that defensive investments do
not usually grow in capital value and returns are generally
lower than those of growth investments over the medium to
long term.
Property and shares
Property and shares are usually classified as growth
investments. As well as income, growth investments aim to
increase the value of the capital invested. While investment
returns are expected to fluctuate over the short term with
market movements and economic changes, growth
investments have the potential to produce higher returns
than defensive investments over the long term.
Alternatives
Alternatives assets fall outside the four traditional asset
classes and include commodities (eg precious metals),
currency, private equity and some forms of infrastructure
(eg public utility assets). Alternatives are included in the
growth allocation as they can have very high levels of
capital volatility in the short term and generally do not
provide high or consistent levels of income. Alternative
investments can produce different returns to both
defensive and growth assets at different points in the
market cycle.
Risk vs return
The power of compounding
All investments provide a certain level of return and are
subject to a certain level of risk. This means that as well as
making money on your investments, there’s also the
chance you could lose money or not make as much as you
expected. All investments carry some risk – due to factors
such as inflation, taxation, economic downturns or a drop
in a particular market.
Compounding is often described as ‘earning interest on
your interest’. Each time you earn a dividend, distribution
or income payment from your investment, you reinvest it to
buy more units or shares. In turn, these reinvested
earnings generate additional earnings. Compounding can
make a huge difference to the value of your investment
over time. To take full advantage of the effect of
compounding, think about starting early and leaving your
money invested for as long as possible.
As a general rule, the larger the potential investment
return, the higher the investment risk and the longer you
need to remain invested to reduce that risk. The amount of
risk involved with an investment can be managed by
matching it appropriately with the length of time you have
available to invest and your tolerance towards volatility or
fluctuations in returns.
Diversification
Another way of managing or reducing investment risk is
through diversification. This is the strategy of investing your
money across a range of different investments. The exact
mix of investments you choose will depend on:
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your financial objectives
the amount of time you have available to invest
your personal tolerance for risk.
Diversification is important because every type of
investment has its ups and downs. Owning a diverse range
of investments can help you achieve smoother, more
consistent investment returns. The more ways you
diversify, the more you can reduce your risk. For example,
you can invest:
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across different investment types or asset classes
(cash, fixed interest, property, shares)
in more than one investment within each type
(eg invest in several different industries and
companies when investing in shares)
in more than one type of fund, and more than one fund
manager, when investing in managed funds
inside and outside of super.
Which asset classes are best for you?
When a financial adviser creates a financial plan, they use
a number of factors to determine which combination of
asset classes will work best for you. These factors include
your attitude to risk, your investment time frame and your
financial and lifestyle goals. The end result or how your
money is invested across the different asset classes, is
known as your ‘asset allocation’.
For example, if you are a risk-averse investor looking for
stable returns or wanting a low-risk, short-term investment
option for a sum of money (eg a home deposit) – your
adviser would probably weight your asset allocation more
heavily towards defensive investments such as cash and
fixed interest.
On the other hand, if you are comfortable with short- term
fluctuations in the value of your investments and want to
invest for more than five years, growth investments such
as Australian and international shares may be the best
option for you.
If you are concerned that your asset allocation does not
match your investment goals or attitude to risk, it’s
important to review your financial plan with your financial
adviser. They can adjust your asset allocation as required
to help you achieve the best possible results.
Key takeaways
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Dollar cost averaging
By implementing a regular investment plan you will be able
to take advantage of ‘dollar cost averaging’. When you
invest a set amount at regular intervals, sometimes you will
purchase units or shares at a higher price, and sometimes
at a lower price. Over time, this spreads out your costs and
insulates you against changes in the value of the assets
you are purchasing.
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Understand your risk profile and consult with
your financial adviser to select investments that
match it.
Diversify across asset classes, industries and
funds to minimise the impact of unexpected
market shocks.
If you take a long term view, you can enjoy the
advantages of dollar cost averaging and
compounding.
Understanding risk and return
The level of risk an investor takes relative to the investment
return they expect to receive is sometimes known as the
‘risk to return ratio’.
As a general rule, the larger the potential investment
return, the higher the investment risk and the longer you
need to remain invested to reduce that risk. See the chart
below for more detailed information on each asset class.
The attributes of each asset class
Source: Colonial First State. Return forecasts above inflation are based on the long-term historical characteristics of each asset class. Past performance is no guarantee of
future performance.
Managing investment risk
If you invest in just one asset class and its value falls, the
value of your investment will drop with it. However, by
investing in several asset classes, you spread your risk
and can offset underperformance in one asset class with
positive performance in another. This could help you
achieve smoother, more consistent returns over time.
Each asset class has its good and bad times, so while a
diversified portfolio will never achieve the top return in any
given year, it will never receive the lowest either.
The table below shows annual returns for the different
asset classes from 1993 to 2012. As you can see, the top
performing asset class one year may deliver the poorest
results the next. This highlights the importance of
diversification as a method of managing risk.
Asset class returns
Annualised last 20 years
Dec 1995
Dec 1996
Dec 1997
Dec 1998
Dec 1999
Dec 2000
Dec 2001
Dec 2002
Dec 2003
Dec 2004
Dec 2005
Dec 2006
Dec 2007
Dec 2008
Dec 2009
Dec 2010
Dec 2011
Dec 2012
Dec 2013
Dec 2014
Australian
shares
9.4%
20.2
14.6
12.2
11.6
16.1
4.8
10.5
-8.6
15.0
27.9
22.5
24.5
16.2
-38.9
37.6
1.9
-11.0
19.7
19.7
14.5
Global
shares
6.0%
26.0
6.2
41.6
32.3
17.2
2.2
-10.0
-27.4
-0.8
9.9
16.8
11.5
-2.6
-24.9
-0.3
-2.0
-5.3
14.1
48.0
7.2
Australian
property securities
10.6%
14.7
26.4
14.1
-6.6
1.4
30.9
9.1
6.2
30.9
34.5
22.8
40.0
-9.2
-48.1
33.0
19.6
-3.5
32.0
9.9
9.9
Australian
fixed interest
6.9%
18.6
11.9
12.2
9.5
-1.2
12.1
5.4
8.8
3.0
7.0
5.8
3.1
3.5
14.9
1.7
6.0
11.4
4.4
2.0
4.4
Cash
Diversified*
5.2%
8.0
7.6
5.6
5.1
5.0
6.3
5.2
4.8
4.9
5.6
5.7
6.0
6.7
7.6
3.5
4.7
5.0
4.0
2.9
2.6
8.5%
20.1
12.7
19.4
14.1
10.0
8.7
3.7
-6.8
9.1
17.7
16.1
16.5
5.3
-20.5
17.0
3.9
-2.4
14.9
20.5
9.1
Source: IRESS, GS&PA Research. Data to 31 December 2014. Past performance is no indication of future performance.
Actual indices returns: This table is based on the standard indices used by investment professionals to measure performance of asset classes. Percentage return over rolling 1
year. Bloomberg Australia Bank Bill Index, Bloomberg Australian Composite Bond Index, FTSE EPRA/NAREIT Global Index (hdg), S&P/ASX 200 Property Accumulation Index
(ASX Property Accumulation Index pre April 2000), S&P/ASX 300 Accumulation Index (ASX All Ordinaries Accumulation Index pre April 2000), MSCI ex Australia (A$). All
dividends reinvested excluding fees and charges.
* Non Actual Returns. The Diversified Portfolio is a portfolio constructed from the returns of these market indices with the asset allocation of: 35% in Australian shares, 25% in
international shares, 25% in fixed interest, 10% in Global property securities, 5% in cash. The Diversified does not represent any Colonial First State portfolio nor the actual
returns that this portfolio achieved because it does not exist. The constructed Diversified Portfolio illustrates how such a portfolio may have performed based on the new market
indices. Each Colonial First State portfolio has a different asset allocation from the illustrated diversified portfolio used above. Past performance is not an indicator of future
performance. The above actual indice returns and non-actual returns for the Diversified portfolio also cannot be directly compared to an individual Colonial First State fund’s
return for many reasons such as they do not include allowances for fees or taxation and do not reflect the asset allocation or stocks held now or over time.
Speak to us for more information
If you would like to know more about asset classes and the fundamentals of investing, talk to a gpl Solutions
Advisory Group financial adviser. They can give you more detailed information on the best approach for
your situation.
www.gplsolutions.com.au 9211 5977
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